The FTSE 100 hosts an array of stocks paying attractive dividends. However, the UK’s lead index hasn’t performed all that well over the past 12 months. In fact, resources stocks are the only part of the market to push upwards.
Many UK stocks are actually down considerably. And while this market correction hasn’t been kind to most investors, it does create opportunities.
So let’s take a look at how I’d use £5,000 to create a second income.
Picking dividend stocks
Naturally if I want to do this, I need to invest in dividend stocks. These tend to distribute income to shareholders regularly. And some have been doing so reliably for many years.
There are certainly some pitfalls to watch out for. For example, I prefer those that can comfortably pay the stated dividends from their earnings, and I’d avoid any that resort to borrowing to reward shareholders.
With many parts of the market down, I’d believe that now is a good time to invest in fallen dividend stocks. That’s because, when stocks go down, dividend yields go up — assuming dividend payments remain constant. And, by buying now, I can lock in higher yields for the long run.
For example, I recently bought Direct Line Group, locking in a sizeable 12% dividend yield.
If I invested £5,000 in dividend stocks now, the best average yield I could hope for would be around 7.5%. That’s sizeable for sure. But that only equates to £375 a year.
Reinvesting my dividends and using a compound returns strategy could help me grow my pot and create more passive income in the long run. I could then start drawing down when I need the money.
After 10 years of reinvesting dividend yields of 7.5%, I’d have £10,500, plus share price gains. This could generate at least £750 a year.
But the longer I leave it, the more I’ll have. After 25 years, I’d have £32,000, plus share price gains. And this could generate £2,400 a year.
But it’s important to remember that share price gains could be considerable, if I invest sensibly. The FTSE 100 is actually four times bigger today than it was 30 years ago.
Where I’d put my money
If I’m trying to get the biggest and most sustainable yield, I’d spread my £5,000 among three stocks, at most. That’s because I’d rather invest in a limited number of companies that I know well rather than a host of companies I can’t accurately research.
For an average 7.5% dividend yield, I’d pick FTSE 100 stocks such Direct Line Group, Lloyds, and Phoenix Group, as well as FTSE 250 firm Close Brothers Group. These financial services firms aren’t the most interesting, but they operate in a discounted part of the market and the yields are sizeable. I’ve recently bought more shares in all of these companies.